January 28, 2024 - Caleb Hinton 

Understanding liquidity – everything you need to know

At LiquidityFinder, we cover everything to do with liquidity. Whether that’s finding a liquidity provider for your business, or simply joining our community, LiquidityFinder is a tool to access industry data, build custom offerings and grow a network. 

Liquidity can be a complex topic, especially for those new to the industry. Here’s our guide on everything you need to know about what liquidity is and how it might be able to help your business, or help you understand the markets.

What is liquidity?

In simple terms, liquidity describes how easily an asset can be converted into cash. An asset with high liquidity can be converted very easily, and subsequently, low liquidity assets are difficult to sell. Liquidity is also referred to when dealing with securities or financial instruments – it’s applicable to anything that can be sold.

In financial markets, liquidity refers to the speed at which an investment can be sold without negatively impacting its price. The liquidity of a company is measured by how quickly that company can meet its financial obligations. Cash flow is therefore an important facet of liquidity.

Liquidity is a measure of how easily an asset can be converted into cash

Types of liquidity

Liquidity is often defined by two categories: market liquidity and financial liquidity.

Market liquidity 

Market liquidity is determined by how quickly an asset can be sold without affecting its market price. In an illiquid market, there are a limited number of buyers and sellers, so the market is much more unstable. In a market with high liquidity, assets can be bought and sold easily and the price won’t fluctuate as there are always buyers and sellers ready.

Accounting liquidity

Also referred to as financial liquidity, accounting liquidity refers to how liquid a business is internally. A business which can meet its short-term financial obligations, for example, paying its debts, is considered more liquid. The ability to sell off parts of the business, or obtain cash quickly also contribute to liquidity.

Liquidity is measured using various ratios, including:

1. Current ratio – this is calculated by subtracting the current assets of the company with its current liabilities.
   
2. Cash ratio – the cash available on hand, relative to the current liabilities
   
   
3. Quick ratio – the ratio of the most liquid assets (cash on hand, money due, other liquid assets) relative to current liabilities.

Essentially, these ratios are to make a simple assessment – does the company in question have enough accessible cash and assets to pay back its debts if it needed to? And could the business be sold if it needed to be? A business that can easily do things is considered highly liquid, and therefore has much greater freedom, stability and appeal to investors.

Why is liquidity important?

Keeping an eye on the liquidity of markets and companies is very important, for a number of reasons. 

Market liquidity

When it comes to financial markets, liquidity determines how the prices behave. Many people refer to liquidity as the ‘grease’ to the engine of the economy.

High liquidity means that a market will be easier to trade in. There will be more buyers and sellers in the market, and therefore the prices will more accurately reflect the fundamental value. 

Liquid markets also create narrower bid-ask spreads, meaning that the difference between the buying and selling price is considerably smaller. This makes the market much easier to trade in, and also contributes to lower transaction costs. It is also essential for risk management, as measuring liquidity can be a tool to determine the direction of the markets.

Liquidity is good for the markets as it assures investors that they can easily enter and exit the market, therefore encouraging greater investment and growth.

Accounting liquidity

Accounting liquidity is crucial for a business, as it provides an indication of how healthy a business is, determining whether the business can continue and whether it can be sold or scaled.

The liquidity of a company can be determined from its balance sheet. All companies are required to complete and maintain a balance sheet. 

Here is Apple’s most recent balance sheet from 2023: 

Apple Reports, First Quarter Results 02.02.2023

As you can see, the assets descend in the order of liquidity – cash and cash equivalents are at the top under current assets, and each listing after becomes less liquid. Non-current assets are long-term assets which can only have their value determined after one year, such as property or machinery – therefore are significantly less liquid assets.

Why is liquidity important in forex?

In forex trading, liquidity plays a huge role. The forex trading market is considered the most liquid market in the world, due to the incredibly high volume of trades made every single day.

The most liquid forex pair is the EUR/USD pair, which makes up 20% of the global trading volume. As a result of this, the EUR/USD has the lowest bid-ask spread.

According to BIS’s Triennial Central Bank Survey, the top 10 most liquid and highly-traded currency pairs are:

1) USD/EUR

2) USD/JPY

3) USD/GBP

4) USD/CNY

5) USD/CAD

6) USD/AUD

7) USD/CHF

8) USD/HKD

9) USD/SGD

10) USD/KRW

OTC foreign exchange turnover by currency pair

"Net-net" basis,¹ daily averages in April in billions of US dollars and percentage share

Source: BIS, OTC foreign exchange turnover in April 2022, Triennial Central Bank Survey

The bid-ask spreads will increase as the list goes down. This is because there is less trading volume, and therefore fewer buyers and sellers. Trades can be made in highly liquid pairs with much less risk of price fluctuation, slippage, or any other major disruptions. As the pairs become less liquid, they become more volatile and more expensive to trade, and also more difficult to trade quickly.

Pairs with higher spreads will also cost more to trade, due to compensation for the market maker for putting their money, and risk, into a less liquid pair.

Conclusion

Liquidity is a crucial part of both how the market functions and how businesses run. 

Liquidity permeates all levels of the market and all businesses. If you are looking for a liquidity provider for your business, then LiquidityFinder is for you.

All users can use our Match Matrix tool to find the perfect liquidity provider, as well as our multi-provider request form, which will help you find partners more easily.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder.